Whenever I pose a question to brokers, developers or lenders about the underlying causes for rising vacancies and declining rents in the office market, invariably I hear the following response: “This is a demand-driven recession, the industry didn't overbuild this time.” The reality is it's also a supply problem in two of the historically biggest job-growth markets, Atlanta and Dallas.
“Those who say it's a demand problem are right — to a point,” says Keith Pierce, research analyst with Dorey Market Analysis Group, which exclusively tracks commercial real estate activity in Atlanta. “The new supply is not helping. There's more building going on than is warranted in the [Atlanta] market.”
Certainly, this economic downturn isn't nearly as bad as the slump in the early 1990s, when buildings were being foreclosed on left and right and auctioned off at fire sale prices. Back then, the commercial real estate market was all but left for dead.
Nevertheless, metro Atlanta's third-quarter numbers are cause for concern. The office vacancy rate for all classes of space — including sublease space — rose to 18.8%, from 17.9% at mid-year and 15.6% at the end of 2001, according to Dorey. Net absorption, which is the key number analysts focus on in assessing the health of a market, stood at a negative 2.4 million sq. ft. as of the third quarter.
To give you an idea of how weak that absorption figure is, in the late 1990s annual net absorption of office space in Atlanta was in excess of 5 million sq. ft. on the plus side. What's more, 2.8 million sq. ft. of new office space is expected to be delivered over the next 12 to 14 months. The good news is that figure is significantly lower than the 9 million sq. ft. delivered in 2000.
Meanwhile, the news coming out of Dallas is equally as troubling. According to CoStar Group, the vacancy rate in Dallas/Fort Worth registered 20.9% in the third quarter. Year-to-date net absorption is a negative 4 million sq. ft. Already this year, 2.7 million sq. ft. of space has been delivered with another 2.1 million sq. ft. under construction. Indeed, supply is a factor.
While the industry can't control demand for office space, it can limit the supply of it. One could argue that many of the projects under construction now in these two markets were in the pipeline before the downturn hit full force, and that it's a case of unfortunate timing. On the other hand, shouldn't the lenders and developers have anticipated that the Internet and telecom bubble would burst, and scaled back development accordingly?
Some irrational exuberance led to the current slump. Throughout the high-tech corridors of the country, which include places like Atlanta, Dallas and most notably San Francisco, firms were leasing space in anticipation of future expansion that never occurred. So when the economy turned, the market not only had to absorb all the excess space that companies threw back on the market but also digest a moderate amount of new construction. To avoid getting burned again, landlords now are focusing heavily on the creditworthiness of the tenant before entering into leases involving big blocks of space.
Ultimately, a good sense of humor comes in handy in times like these. As Maria Sicola, senior managing director of research for Cushman & Wakefield, recently joked: “The new equilibrium vacancy rate in Dallas is somewhere around 25%.”